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2/17/2015

anarticletoreadandthinkoverfordiscussiontomorrowSoumyajitlahiri

an article to read and think over for discussion tomorrow

To: @PGP

201416SectionB <PGP201416SectionB@IIMB.ERNET.IN>;

DearAll:
Seethearticlebelow(linkgiventoo).Itrelatestothediscussionwehadinclasstodayaboutfallingoilpricesand
whowasgainingandwhowaslosing.ItalsoaddressesthequestionregardingVenezuelashighinflationdespite
fallingoilprices.Asexplainedthecountrysproblemisthatitsforexearningshavefallenwiththefallinoilprices,
whichisitsmajorexportitem.Asaresult,itisunabletofinanceitssocialprogramsthroughtheserevenuesand
alsounabletoimportsupplies(includingessentials)duetoshortageofforeignexchange.Thisshortageiscreating
inflationarypressures.Ifthegovernmentcontinueswithitssocialspendingcommitments,thenthiswouldfurther
fuelinflationthroughmonetizationoffiscalspending(thearticlementionsaboutthegovernmentprinting
bolivares)givenshortageofrevenues.Alternatively,thegovernmentneedstobeabletoaccessloansandother
formsofforeigncredittobridgetheforexgapduetofallingexports.So,thisisanenvironmentofanASmovement
upwardduetoshortageofproductsandADmovingdownwardduetofallingexportsbutADpressuresremaining
withfiscalspendingandmonetization.Thecountryhasenteredazoneoflowgrowthandrisingprices.

http://www.economist.com/news/international/21627642americaanditsfriendsbenefitfallingoilpricesits
moststridentcritics

Canyouthinkthroughtheexamplesgivenbelowforsomeoftheothercountriesandhowtheyareaffectedby
fallingoilprices,intermsoftheADASframework?Wecandiscussinclasstomorrow.

Cheaperoil
Winnersandlosers

Americaanditsfriendsbenefitfromfallingoil
pricesitsmoststridentcriticsdont
Oct25th2014|CAIRO,CARACAS,MOSCOWANDWASHINGTON|Fromtheprintedition

INEARLYOctobertheIMFlookedatwhatmighthappentotheworldeconomyifconflictinIraqcaused
anoilpriceshock.FightersfromIslamicState(IS)werepushingintothecountrysnorthandthefund
worriedaboutasharppricerise,of20%inayear.GlobalGDPwouldfallby0.51.5%,itconcluded.Equity
pricesinrichcountrieswoulddeclineby37%,andinflationwouldbeatleasthalfapointhigher.
https://outlook.office365.com/owa/projection.aspx

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ISisstilladvancing.Russia,theworldsthirdbiggestproducer,isembroiledinUkraine.Iraq,Syria,
NigeriaandLibya,oilproducersall,areinturmoil.ButthepriceofBrentcrudefellover25%from$115a
barrelinmidJunetounder$85inmidOctober,beforerecoveringalittle(seechart).Suchashifthas
globalconsequences.Whoarethewinnersandlosers?
Thefirstwinneristheworldeconomyitself.A10%changeintheoilpriceisassociatedwitharounda
0.2%changeinglobalGDP,saysTomHelblingoftheIMF.ApricefallnormallyboostsGDPbyshifting
resourcesfromproducerstoconsumers,whoaremorelikelytospendtheirgainsthanwealthysheikhdoms.
Ifincreasedsupplyisthedrivingforce,theeffectislikelytobebiggerasinAmerica,whereshalegas
drovepricesdownrelativetoEuropeand,saystheIMF,boostedmanufacturedexportsby6%compared
withtherestoftheworld.Butifitreflectsweakdemand,consumersmaysavethewindfall.

Todaysfallingpricesarecausedbyshiftsinbothsupplyanddemand.Theworldsslowingeconomy,and
stalledrecoveriesinEuropeandJapan,arereiningbackthedemandforoil.Buttherehasbeenabigsupply
shock,too.ThankslargelytoAmerica,oilproductionsinceearly2013hasbeenrunningat1m2mbarrels
perday(b/d)higherthantheyearbefore.Otherinfluencesareactingasabrakeontheworldeconomy(see
article).Butapricecutof25%foroil,ifmaintained,shouldmeanthatglobalGDPwillberoughly0.5%
higherthanitwouldbeotherwise.
Somecountriesstandtogainalotmorethanthataverage,andothers,toloseout.Theworldproducesjust
over90mb/dofoil.At$115abarrel,thatisworthroughly$3.8trillionayearat$85,just$2.8trillion.
Anycountryorgroupthatconsumesmorethanitproducesgainsfromthe$1trilliontransferimporters,
mostofall.
Chinaistheworldssecondlargestnetimporterofoil.Basedon2013figures,every$1dropintheoilprice
savesitanannual$2.1billion.Therecentfall,ifsustained,lowersitsimportbillby$60billion,or3%.
Mostofitsexportsaremanufacturedgoodswhosepriceshavenotfallen.Unlessweakdemandchanges
that,itsforeigncurrencywillgofurther,andlivingstandardsshouldrise.
CheaperoilwillalsohelpthegovernmentcleanupChinasfilthyairbyphasingoutdirtyvehiclefuels,
suchasdiesel.Lighterfuelsaredearerand,undercurrentplans,driverscouldpayupto70%oftheextra
lowerpriceswillsoftenthatblow.Moregenerally,saysLinBoqiangofXiamenUniversity,lowerprices
shouldsupportthegovernmentseffortstoreducesubsidies(ithasalreadyfreedsomegasprices,and
electricitypricesareexpectedtofollownextyear).
TheimpactonAmericawillbemixedbecausethecountryissimultaneouslytheworldslargestconsumer,
importerandproducerofoil.Onbalancecheaperoilwillhelp,butnotasmuchasitusedto.Analystsat
GoldmanSachsreckonthatcheaperoilandlowerinterestratesshouldaddabout0.1percentagepointsto
growthin2015.Butthatwillbemorethanoffsetbyastrongerdollar,slowerglobalgrowthandweaker
stockmarkets.
Extractingoilfromshaleisexpensive.Sowhentheoilpricedrops,Americaisoneoftheplacesmostlikely
topullback(ArcticandCanadiantarsandsproducersareevenmorevulnerable).AccordingtoMichael
CohenofBarclays,abank,a$20dropintheworldoilpricereducesAmericanproducersearningsbefore
interestby20%,andonlyfourfifthsofshalereservesareeconomictoextractusingcurrenttechnology
withBrentaround$85.Howquicklyproductionwillfallasaresult,though,isunclear,sinceproducers
costsvaryandsomehavelockedinpricesviahedging.Theimpactwillalsovarybyregion.IfImin
California,itsprettyclearcutthatthisisagoodnewsstory,saysMichaelLevioftheCouncilonForeign
https://outlook.office365.com/owa/projection.aspx

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Relations,athinktank.IfIwereinNorthDakota[thebiggestshaleoilstate],Iwouldbealotmore
nervous.
Americaisanetimporter,solowerpricesmeanAmericansgettokeepmoreoftheirmoneyandspenditat
home.Butthestimulativeimpactislessthanitusedtobe,sinceimportsarebecominglessimportant,and
oilisshrinkingasashareoftheeconomy.TheEnergyInformationAdministration,anindependent
governmentagency,expectsnetoilimportstodropto20%oftotalconsumptionnextyear,thelowestshare
since1968.Intheearly1980s,whenoilaccountedforover4%ofGDP,a1%pricedropwouldboost
outputby0.04%,saysStephenBrownoftheUniversityofNevada,LasVegas.Thathadfallento0.018%
by2008,andhereckonsitisnowabout0.01%.
Cheaperoilcouldmakemoreofadifferencetomonetarypolicy.Inflationexpectationshavebecomemore
stablesincethe1980s,whichmeansthattheFedfeelslessneedtoactwhenoilpricesshift.Butwith
inflationbelowits2%target,itwillfretthatfallingoilpricescouldbepushingexpectationsdown,making
ithardertokeepinflationontarget.Itcoulddecidetokeepinterestratesatzeroforlonger,orevenextend
itsbondbuyingprogramme(quantitativeeasing).
FearsofdeflationapplywithgreaterforceinEurope.EnergyimportsintotheEuropeanUnioncost$500
billionin2013,ofwhich75%wasoil.Soifoilpricesstayat$85,theoverallimportbillcouldfalltounder
$400billionayear.
Butthebenefitswouldbemutedtwiceover.First,inflationintheeurozoneisevenlowerthaninAmerica.
MarioDraghi,theheadoftheEuropeanCentralBank,claimsthat80%ofitsdeclinebetween2011and
September2014wascausedbyloweroilandfoodprices.Oilat$85couldleadtodeflation,provoking
consumerstoreininspendingfurther.Second,Europeanenergypolicyisonlypartlytodowithpriceand
efficiency.EuropeansarealsotryingtoreducedependenceonRussiaandtocutcarbonemissionsby
turningawayfromfossilfuels.Cheaperoilmakestheseaimsslightlyhardertoachieve.
Reapingthebenefits
Butonegroupofcountriesgainsunambiguously:thosemostdependentonagriculture.Agricultureismore
energyintensivethanmanufacturing.Energyisthemaininputintofertilisers,andinmanycountries
farmersusehugeamountsofelectricitytopumpwaterfromaquifersfarbelow,ordepletedriversfaraway.
Adollaroffarmoutputtakesfourorfivetimesasmuchenergytoproduceasadollarofmanufactured
goods,saysJohnBaffesoftheWorldBank.Farmersbenefitfromcheaperoil.Andsincemostofthe
worldsfarmersarepoor,cheaperoilis,onbalance,goodforpoorcountries.
TakeIndia,hometoaboutathirdoftheworldspopulationlivingonunder$1.25aday.Cheaperoilisa
threefoldboon.First,asinChina,importsbecomecheaperrelativetoexports.Oilaccountsforaboutathird
ofIndiasimports,butitsexportsarediverse(everythingfromfoodtocomputingservices),sotheyarenot
seeingacrosstheboardpricedeclines.Second,cheaperenergymoderatesinflation,whichhasalready
fallenfromover10%inearly2013to6.5%,bringingitwithinthecentralbanksinformaltargetrange.This
shouldleadtolowerinterestrates,boostinginvestment.
Third,cheaperoilcutsIndiasbudgetdeficit,now4.5%ofGDP,byreducingfuelandfertilisersubsidies.
Thesearehuge:alongwithfoodsubsidies,thetotalis2.5trillionrupees($41billion)intheyearending
March201514%ofpublicspendingand2.5%ofGDP.Thegovernmentcontrolsthepriceofdieseland
compensatessellersfortheirlosses.But,forthefirsttimeinyears,sellersaremakingaprofit.AsinChina,
cheaperoilshouldreducethepainofcuttingsubsidiesandonOctober19thNarendraModi,Indiasprime
minister,saidhewouldfinallyenddieselsubsidies,freedieselpricesandraisenaturalgasprices.
https://outlook.office365.com/owa/projection.aspx

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TheInternationalEnergyAgency,anoilconsumersclub,reckonsthattheglobalcostofsubsidisingenergy
consumption(mostlyindevelopingcountries)is$550billionayear.Thefallintheoilpriceshouldreduce
that,allelsebeingequal,toabout$400billion.Thatmeansmanycountriesfaceachoice:seizethemoment
todismantlesubsidies,orkeeponhandingoutgoodiesthatnowcostless?Eitherway,theywillbenefit
byendinganeconomicdistortion(thoughwithsomeriskofaconsumerbacklash),orbyreducingitsfiscal
costforawhile.

ThechoiceisparticularlystarkforoilimportersintheMiddleEast(seechart).EnergysubsidiescostEgypt
6.5%ofGDPin2014,Jordan4.5%,andMoroccoandTunisia34%.A20%fallintheoilpricewould
improvethefiscalbalancesofEgyptandJordanbyalmost1%ofGDP,saystheIMF.But,fearsMrBaffes,
theefficiencygainsmaynotbeenoughtopersuaderegimes,especiallyshakyones,tocutsubsidiesthat
mostlybenefitthepoliticallyinfluentialmiddleclasses.
Manyothercountriesarealsowrestlingwithenergysubsidies.Indonesiaspendsaboutafifthofitsbudget
onthem.Gulfoilexportersareevenmoreprofligate:Bahrainspends12.5%ofGDPandKuwait,9%.
Brazilwantsahighoilpricetoattractinvestmenttoitsultradeepoffshore(prsal)oilreserves.Butcheap
oilisaboontoitsfarmers,andintheshorttermtoPetrobras,itsstatecontrolledoilfirm,whichhasbeen
forcedtoimportatworldpricesandsellatagovernmentcappedrateinordertokeepinflationartificially
low.Forthefirsttimeinyears,itisnolongermakingalossontheimportsitsells.

Contrastingfutures

Itmightseemthatthecountrywhichistheworldslargestexportermustloseout.Withoilat$115abarrel,
SaudiArabiaearns$360billioninnetexportsayearat$85,$270billion.Itsbudgethasalmostcertainly
goneintothered.PrinceAlwaleedbinTalal,aninfluentialbusinessman,calledlowerpricesa
catastropheandexpressedastonishmentthatthegovernmentwasnottryingtopushthembackup.But
SaudiArabiaslongterminterestmayinfactbeservedbyaperiodofcheaperoil.Itcanaffordone,unlike
mostotherexporters.Thoughpublicspendinghasriseninrecentyears,itsforeignreserveshaverisenmore.
Netforeignassetswere2.8trillionriyals($737billion)inAugustoverthreeyearscurrentspending.It
couldfinancedecadesofdeficitsbyborrowingfromitselfevenifoilwerecheaperthanitisnow.
OverthepastyearproductionbynonOPECcountries,suchasRussiaandAmerica,hasrisenfrom55mb/d
to57mb/d.TheSaudismightconcludethatthemainbeneficiariesofdearoilhavebeennonOPEC
members.Someofthenewoutputishighcost,unliketheSaudis.Aperiodofcheaperoilcoulddrivesome
highcostoperatorstothewall,discourageinvestmentinothersandlettheSaudisregainmarketshare.
Inthemid1980sSaudiArabiacutitsoutputbyalmostthreequartersinanattempttosustainprices.It
workedandothercountriescashedinbuttheSaudisthemselvessufferedabiglossofrevenuesand
markets.Theyseelittlereasontomakesuchasacrificeagain.
Blowingwindfalls
SaudiArabiacansurvivelowpricesbecause,whenoilwas$100abarrel,itsavedmoreofthewindfallthan
itspent.Thebiggestlosersarecountriesthatdidnt.Notableamongthesearethreevitrioliccriticsof
America:Venezuela,IranandRussia.
https://outlook.office365.com/owa/projection.aspx

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Howeverlowtheoilpricefalls,NicolsMaduro,Venezuelaspresident,declaredonOctober16th,we
willalwaysguarantee...thesocialrightsofourpeople.Therealityisquitedifferent.HugoChvez,his
predecessor,dismantledafundintendedtosquirrelawaywindfalloilprofits,spentthemoneyandranup
tensofbillionsofdollarsindebt.Thatdebtisnowcomingdue.Earlierthismonthaheftyservicepayment
tookVenezuelasforeignreservesbelow$20billionforthefirsttimeinadecade.Everydollarofftheprice
ofabarrelcutsroughly$450m500moffexportearnings.ByDeutscheBankscalculation,thegovernment
needsoilat$120abarreltofinanceitsspendingplanshigherthanbeforetherecenttumble.
So,unlikeotheroilexportersbudgets,Venezuelaswasalreadyintrouble.Lastyearsfiscaldeficitwasa
reckless17%ofGDP.Inresponse,thegovernmentprintedbolvares,pushinginflation(evenonofficial
measures)over60%.IndustrialproductionisgrindingtoahaltandStandard&Poors,aratingsagency,
downgradedVenezuelasdebttoCCC+lastmonth.Analystshavelongthoughtitwouldmoveheavenand
earthtoavoiddefaultnotleastbecauseithasoverseasassetsthatcreditorscouldseizeanddepends
heavilyonfinancialmarkets.Butthedwordisincreasinglyoftenheard.
TheimpactofVenezuelasoilrelatedtravailsmaybefeltbeyonditsborders.Thecountryrunsa
programmecalledPetroCaribe,whichprovidescountriesintheCaribbeanwithcheapfinancingtobuy
Venezuelanoil.ForGuyana,Haiti,JamaicaandNicaraguaannualdeferredpaymentsunderPetroCaribeare
wortharound4%ofGDP.ButitcostsVenezuelasgovernment$2.3billionayear.SoifVenezueladecides
tocutbackonitslargesse,theshockwaveswillbefeltthroughouttheCaribbean.
IranisevenmorevulnerablethanVenezuela.Itneedsoilat$136abarreltofinanceitsspendingplans,
mostoftheminheritedfromtheprofligateandinefficientgovernmentofMahmoudAhmadinejad.Lastyear
itspent$100billiononconsumersubsidies,about25%ofGDP.Sanctionsmeanitcannotborrowitsway
outoftrouble.
HassanRouhani,whotookofficelastyear,hasreestablishedadegreeofmacroeconomicstability.The
centralbanksaidtheeconomygrewinthesecondquarterof2014forthefirsttimeintwoyears.Buthewas
electedonthepromiseofimprovinglivingstandards.Itisnotyetclearwhetherloweroilpriceswillforce
furtherreforms,andincreasepressureforadealwithAmericaoverIransnuclearprogramme,orwhether
fallingrevenueswillboostsupportforconservativeswhoarealreadymakingtroubleforhim.
ForRussiatheimpactwillbelessdramatic,atleastatfirst.Itsdraftbudgetfor2015assumesoilat$100a
barrelbelowthat,itwillbeharderforVladimirPutin,thepresident,tokeephisspendingpromises.
Somethingsimilarhappenedwhentheoilpricefellinthemid1980s,leavingtheindebtedSovietUnion
cashstrapped.
ButRussianowhasreservesof$454billiontocushionagainstoilpricefluctuations.Moreimportant,the
roublehasfallen.Nextyearsbudgetassumesadollarisworth37roubles,soitbalanceswithoilat3,700
roubles.Abarrelcurrentlycosts3,600roubles(amuchsmallerfallthanthedollarprice),becausethe
currencyhasplunged20%thisyear.Withoilat$8085abarrelRussiawouldprobablyrunabudgetdeficit
ofonlyabout1%ofGDPnextyear.
Allthesame,thecountrywillsufferaslowdown.Foryears,realincomesrose,thankstowageincreasesin
thestatesector.Theincreasedspendingwentonimportsmadecheaperbyastrongcurrency.Sotheslidein
theroubleiscuttinglivingstandardsbymakingimportsdearer.Westernsanctionshaveclosedcapital
marketstoRussianfirms,evenprivateones.Businessactivityiswaning.Aseniorfinanceministryofficial
saystheshareofnonoilandgasrevenuesinthebudgetisshrinking,makingRussiamoredependenton
oil.Someanalyststhinkgrowthin2015willbejust0.52%,comparedwithabout4%ayearin201012.
Inflationis8%.Russia,itseems,isheadedtowardsstagflation.
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FormostgovernmentsVenezuelasisapossibleexceptioncheaperoilislikelytohaveamodestimpact
atfirst.EvenMrPutinmaybeabletorideoutstagflationforawhile.Butovertime,theconsequencesare
likelytogrow.Theyearsof$100abarreloilalsosawtheriseofaBeijingconsensustowardsmore
economicinterventionism.Perhapsaperiodof$85oilifthatweretohappenmightusherinanother
shiftinattitudes,assumptionsandpolicies.
Corrections:Inanearlierversionofthisarticlewesaidthattheoilpricehasfallenfrom$115abarrelinmidJuly.Weshould
havesaidmidJune.ThiswascorrectedonOctober23rd2014.Wealsosaidthata$20dropintheworldoilpricereduces
Americanproducers'profitsby20%.Weshouldhavesaid"earningsbeforeinterest".ThiswascorrectedonOctober28th2014.
Sorry.

Fromtheprintedition:International

RupaChanda
ProfessorofEconomics
IndianInstituteofManagement
BannerghattaRoad
Bangalore560076
India
Ph:918026993273(O)
Fax:918026584050
Email:rupa@iimb.ernet.in

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